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Working with Independent Contractors: Understanding Tax Requirements

By Caron Beesley
If your business is growing and you need to supplement your core capabilities and services with extra personnel, there are many benefits to hiring an independent contractor.

Bringing on a self-employed contractor, instead of adding to direct employee headcount, can save a small business owner as much as 30 percent (per worker) in additional payroll taxes and benefits. It also introduces flexibility in hiring and firing, and can reduce strains on office space, training budgets, and more.

It all sounds fairly straightforward. However, in legal terms, the line between an independent contractor and an employee is not always clear. Your workers are not independent contractors because you say they are - and there can be costly tax implications if you get it wrong.

Before you engage an independent contractor make sure you are clear on the nature of your relationship and familiarize yourself with the government criteria used to judge the status of that worker.

Below are three steps you need to take to ensure regulatory compliance when hiring an independent contractor.

1. Understand the Significance of Worker Classification

Misclassifying workers is a common business slip-up. Take, for example, this scenario described in a great article by Minda Zetlin on Inc.com about common and costly mistakes that businesses make when it comes to classifying contractors.
In the article, Zetlin poses a seemingly clear cut question:
"Which of these workers qualifies as an independent contractor?

1. A newspaper carrier paid for each copy delivered
2. A knife salesman who works on commission, rents his own office, and pays his own staff
3. A consultant who works part time for a marketing firm"

I must admit, my immediate response was "all of the above" and, indeed, each of the workers described was labeled as a contractor by the company he or she worked for. However, only the third example is a true contractor. The first two examples are, in fact, legal company employees, as determined in court rulings.

It is critical that you, the employer, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors. Getting it wrong can be costly resulting in penalties and back-tax payments for the business owner.

2. Know the Regulatory Criteria Used to Judge Worker Status

Here is a basic definition from the IRS of what classifies a person as a contractor as opposed to an employee:

Independent Contractor - The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result. Essentially independent contractors are considered to be in business for themselves. They take care of their own tax obligations and benefits.

Employee - Anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

If you are not clear whether a particular worker is an employee or an independent contractor, you should file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. They will review the facts and circumstances for you and make an official determination of the worker's status.

The Small Business Administration also has more information that can help you determine the difference between an employee and a contractor.

3. Understand and Maintain Your Tax Obligations with Regards to Contractors

If you determine that you are using an independent contractor, you will need to file some paperwork with the IRS and pay the associated taxes. This means maintaining W-9 forms, contractor's business licenses and certification of insurance, as well as filing a 1099-MISC form to report payments.

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